Crude Oil Trading

Oil market overview

This article gives an overview of the oil market and its dynamics. Furthermore, analyzes the types of oils, their characteristics and the factors that can influence the supply and demand and thus the price of the oil in the market.

The world crude oil market: The oil industry is a global enterprise that employs millions of workers around the world and generates hundreds of millions of dollars. The oil sector, thus, is considered to be the largest in the world in terms of dollar value. In regions which house the major National Oil Companies, these corporations contribute significantly to the national GDP. The main products of the oil industry are constituted by fuel oil and gasoline (petroleum). Petroleum is one of the primary materials for the chemical industry: it is used for pharmaceutical products, plastics, solvents and fertilizers. Oil plays a key role in industrial production and therefore is a resource of critical importance for all the countries in the world. During the last decade, a growing negative sentiment against the oil industry has been emerging. Recent environmental disasters such as the BP oil spill (also referred to as the Deepwater Horizon Gulf Of Mexico Oil Spill) has given a negative spotlight on the whole oil industry. Moreover, the companies working in the oil and gas sector are being threatened by the increasing importance and attention given to renewable and alternative energies. Due to these phenomena, the government is putting pressure on these companies through increased legislations. Despite the increasing negative sentiment, the oil and gas industry is still extremely successful, and is experiencing a strong and rapid growth. It is estimated that the worldwide consumption of oil is 30 billion barrels per year, and this amount is mostly utilized by the developed countries. Moreover, oil also represents the major source of energy consumed around the globe and accounts for 32% in Europe, 35% in Asia, 40% in North America, 42% in Africa, and 51% in Middle East.

Major oil futures exchanges Oil is one of the main commodities traded around the world. This section is focused on three among the major exchanges in which a large amount of oil futures contracts are traded.

CME: The Chicago Mercantile Exchange (CME) was founded in 1895 in Chicago, Illinois, USA, and is one of the most important markets for derivate worldwide. Despite its importance, the CME is not the first American futures market as the Chicago Board of Trade ( CBOT ) was founded in 1848. In 2007 the CBOT was incorporated within the CME Group. In August 2008, the acquisition of the New York Mercantile Exchange (NYMEX) was completed. For a long time the only contracts traded on the CME had underlying assets as agricultural products such as grain, flour bacon etc. We have to wait until 1972 to witness the debut of the first “financial futures”. In that year, futures on seven currencies (British pound, Canadian dollar, German mark, French franc, Japanese yen, Mexican peso , Swiss franc) began to be traded. The development of financial markets in the following years led to an exponential growth of the tools available to operators. Between 1975 and 1977, the CBOT launched the first futures on interest rates. Particularly important was the debut of the contract on T- Bonds, the title of the US government, which quickly became the most traded futures in the world. The period between ’81 – ’82 was also crucial because the CME introduced the contract on Eurodollar deposits and then the first futures on a stock index , the S&P 500. In 1997, the CME opened its doors to private traders thanks to the invention of E-mini S&P 500 futures, contracts of smaller size than the standard, negotiated with margins also accessible to noninstitutional traders. Currently, the range of products traded at the CME Group ranges from futures and options on indices, currencies, interest rate, commodities and derivatives up to the economic indicators (e.g. inflation) and the evolvement of weather conditions. Exchanges at the CME take place in two ways. One being the classic system of “shouting”, in which specialized operators are physically present in the room for negotiation and exchange contracts through a set of codified hand gestures (impossible to do so by voice as this would be too chaotic).

This process was supplemented in 1992 with an online platform that allows traders to operate remotely via dedicated terminals .

ICE The Intercontinental Exchange Group (ICE), is a complex network composed of clearing houses and exchanges created for financial and commodity markets. The group created in May 2000 is headquartered in Atlanta, Georgia and the ICE actually owns 23 exchanges and marketplaces all around the globe. This network, different from other marketplaces, operates completely as an electronic exchange, which connects firms and individuals looking to trade oil, electric-power, natural gas and general commodity derivatives. Moreover, the ICE also facilitates the exchange of emission (cap-and-trade) and OTC energy exchanges. In 2001 ICE acquired the International Petroleum Exchange (IPE), which is now called ICE Futures Europe. Furthermore, in 2007, the ICE also acquired the New York Board of Trade, that is now known as ICE Futures US.

NYMEX The New York Mercantile Exchange (NYMEX) is arguably the largest market for the exchange of futures, as well as a major headquarters for the commercialization of energy and precious metals. Among other things, the exchange is also characterized by a major characteristic: the NYMEX stands out for its 135 years history of integrity and transparency in pricing. The transactions that take place here limit the risk of default by the counterparty. Trading relates to energy, metals, futures on environmental goods and some options relating to the system of e-commerce. The NYMEX refers to markets for the exchange of materials such as crude oil, diesel fuel, gasoline, natural gas, electricity, propane, uranium and other naturally occurring assets such as gold, silver, aluminum, platinum. Many varieties of options are available, including, options on the price differential between crude oil and its derived products (or so-called “crack spreads”), monthly futures contracts (better known in the U.S. as “calendar spreads”) and the European and Asian options . In essence the NYMEX offers products that ultimately aim to minimize the risk of default by the counterparty, as mentioned before . Usually, investors who choose to entrust their portfolio choices on the New York Mercantile Exchange are attracted by features such as excellent liquidity, the offering of stocks and bonds. The prices relative to prices in this market are often used as a reference by buyers from sellers who operate in the markets that exchange materials such as energy and precious metals.

Factors influencing the market The worldwide oil market is strongly affected by several factors, which can have a dramatic effect on the spot price. This section presents ten main variables that can influence the market.

OPEC The Organization of the Petroleum Exporting Countries is a consortium composed of 13 nations: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. This organization is the largest single entity that can affect, through its choices, the world’s oil supplies. OPEC is accountable for more than 40% of the world’s production of oil. OPEC decides the policy of the member countries in order to meet the global oil consumption. This entity can strongly affect the price of the crude oil, just by changing the production levels among its members.

Supply and Demand The amount of oil present in the inventories balances the supply and demand. When the production exceeds the amount of the demand, the surplus can be stored. In the opposite way, if the consumption exceeds the demand, inventories can be exploited in order to cover the incremental demand: the strong relationship between oil inventories and oil prices makes corrections in each direction possible. Non-OPEC suppliers produce almost 60% of the global oil and thus outpace the OPEC countries in terms of production by 50%. Despite this difference in production levels the non-OPEC countries do not have sufficient reserves to control the price, and therefore they have only the ability to respond to market fluctuations.

Legislation As already mentioned during the oil market overview, a vast part of the global oil reserves and production are controlled by companies strongly linked to the government. This means the world oil market is heavily affected by political decisions and so this market is far to be a competitive place. Moreover the variation in energy policy and taxation in oil-rich countries can also influence the world price of oil.

Political unrest This is another factor that has always strongly affected the price of oil: if an oil-producing nation becomes politically unstable (e.g. Iranian Revolution in 1979), supplier markets react by increasing the prices of oil, so that the remaining supplies are still available to the highest bidder. The shortage in supply does not need be become real, only the perception of a possible decrease in production can drive the price up.

Production costs Physical factors determine most of the costs of the oil production: from the location of reserves to the characteristics and the property of the oil found, and ultimately to the extraction procedures. Oil is a nonrenewable natural resource, therefore substantial investments are required for the discovery of new reserves and their development.

Financial markets Oil brokers work as an intermediary to match buyers with sellers of crude oil, one of the major contracts traded are the futures contracts. Futures give the possibility to buyers and sellers to hedge their position against possible oil price fluctuations that could affect their profitability. Oil producers sell oil futures to lock their price for a determined amount of time while the counterpart purchases oil futures in order to receive a future delivery of oil at a predetermined price.

Weather Being a commodity, the seasonal cycles in weather influences the demand of oil. During the winter, the amount of heating oil consumed increases, while in the summer people use a larger amount of gasoline to travel. Although markets expect those increased demand periods, the oil prices still raise and level out with the changes of the season every year. Beside the seasonality effect, extreme weather conditions can physically affect the production of oil by damaging infrastructures, interrupting supply, and therefore inducing pricing spikes.

Speculators Speculators can influence the cost of crude oil by buying and selling futures contracts on the open market. This phenomena has a huge impact on the price due to particular requirements applied to these contracts. The speculator is not required to have the total sum required for the transaction, but just a small fraction of it (margin). These low margins requirements create a leverage effect. In recent years, it was believed that speculators were driving up the price of oil to the peak, in 2008, at more than $140/barrel. By the end of 2009, prices fell to $30/barrel as there was not a real demand supporting the inflated price level.

Exchange value of the dollar Oil is bought and sold internationally using the US dollar currency. A depreciation of the dollar usually tends to raise the oil demand and increase the price of the oil. On the other hand, the appreciation of the dollar decreases the real income in consumer countries, therefore reducing the demand and the price of oil.

Non-OECD demand While oil consumption in the Organization of Economic Cooperation and Development countries has declined during the last 10 years, the consumption in countries that are not part of the OECD has increased more than 40% during the same period. In particular the countries that registered the highest growth of consumption were China, India and Saudi Arabia.